What are preference shares?

Dividends on preference shares tend to be at a fixed level set in advance, unlike the variable (or often no) dividend payable on ordinary shares. Usually paid twice a year, preference share dividends must be paid out in full before any dividend can be paid on ordinary shares. However, it’s still possible preference shares will not receive a dividend in any year, as profits must exist from which to pay.

If the company is wound up, preference shareholders are entitled to be repaid their capital contribution before ordinary shareholders receive anything. Like ordinary shares, however, preference shareholders will only be paid once other creditors have been paid in full.

Preference shares generally do not carry voting rights, which may limit their appeal. Usually, they can only vote in specific, extraordinary circumstances – for example, if a proposed change would affect the rights of the preference shareholders or if dividends due on preference shares remain paid.

Preference shares – a mix between ordinary shares and corporate debt

A preference share is sometimes described as a hybrid between an ordinary share and corporate debt, with some features of each.

Preference shares have the following features in common with ordinary shares:

• They are perpetual shares, with (usually) no requirement for the company to repay the amount invested during its lifetime. It is only on liquidation that a company has an obligation to return capital to shareholders.
• Like other types of shares, a company allots new shares that may then be transferred from one holder to another.
• Dividends can only be paid out of distributable profits.
• Dividends are not deductible as an expense when working out the company’s tax liability.
• Dividend payment is not obligatory. The directors of the company typically have discretion over whether a dividend should be paid or to reinvest profits into the business.
• They do not create any charge over the assets of the company.
• They sit below all secured and unsecured creditors, and only rank for repayment ahead of ordinary shareholders.

At the same time, preference shares have some features in common with corporate debt instruments:

• They carry a fixed rate of dividend, like the interest payment on corporate debt.
• They do not carry the right to vote.
• They rank ahead of ordinary shareholders for return of capital in any liquidation event.

With this combination of features, in principle a preference share will potentially achieve higher rewards but with higher risk than a debt instrument of the same company but lower rewards at lower risk than the company’s ordinary shares.

Features that may apply to preference shares

There are many additional features that can be added, individually or in combination, to preference shares. These may make them more attractive to potential shareholders or the company issuing them. The exact nature and any features of an issue of preference shares should be set out in the company’s articles of association.

Here are the main features you’re likely to find attached to preference shares:

Advantages of preference shares for investors

Compared with ordinary shares:

1. They provide somewhat more security of income than ordinary shares, because preference share dividends must be paid before a dividend can be declared on ordinary shares.
2. As the dividend is set at a fixed level, preference shares can be useful for investors looking for a level of certainty of income – compared to ordinary share dividends, which may be more irregular in both frequency and amount. (However, lack of profits may still mean preference dividends are not paid.)
3. Initial income is likely to be at a higher level than ordinary shares, to compensate for the fact that preference shares do not benefit in the same way from growth in dividends and capital value over time. They may therefore be useful for those to whom a higher income is important.
4. Additional features, like convertibility and cumulation, can be useful to investors.
5. Preference shares rank ahead of ordinary shares in terms of return of capital in a liquidation event.
6. Even though preference shares usually carry no ability to vote on general matters, the holders will typically be able to vote on matters that directly affect their rights.

Compared with corporate bonds:

1. A preference share should be expected to yield a higher return than a corporate bond issued by the same company.
2. Income via dividends on shares may be more tax-efficient than the interest received on a corporate bond, with a £2,000 tax-free dividend allowance available and a 7.5% rate of tax on dividends that fall within the basic rate band.

Advantages of preference shares for the issuing company

Compared with ordinary shares:

1. With features like cumulation and convertibility included, preference shares may be tailored to be attractive to particular people who the company wishes to invest.
2. Preference shares will not dilute voting rights, which will remain with the existing ordinary shareholders in their existing proportions. That may allow the existing owners to retain control over the company, which might be lost if further ordinary shares were issued instead.

Compared with corporate bonds:

1. There is no obligation to pay dividends if there are no profits, unlike the payment of interest on corporate debt.
2. Preference shares can provide longer-term capital, with no fixed date at which it must be repaid.
3. Preference shares do not require assets to be pledged as security, either on a secured or unsecured basis. That also leaves any mortgageable assets available to be used as charges on loans in the future.
4. With the different features that can be incorporated into preference shares, there is significant flexibility to establish terms that best suit the current needs of the company and will attract the right investors.

Disadvantages of preference shares for investors

Compared with ordinary shares:

1. All other things being equal, because they face lower risk of non-payment of dividends and capital, investors should expect lower returns from preference shares compared to ordinary share capital.
2. Unlike ordinary shares, preference shares with a fixed dividend (except if they are participating preference shares) will not share in a higher dividend during times when the business is succeeding.
3. If dividends on preference shares are fixed in monetary terms, inflation will reduce the real value of the dividends received over time. Typically, ordinary shares will get the benefit of growth in dividends (and capital value) over time, often keeping pace with or exceeding inflation.
4. With no voting rights, the holders of preference shares have very little say over the running of the company.
5. There is a smaller market for preference shares than ordinary shares, so they may be harder to buy and sell. Anyone in a rush to sell, particularly the sale of a large number of shares, may have to accept a lower price.

Compared with corporate bonds:

1. If the company has insufficient profits in a year then any entitlement to a dividend payment is lost (unless it rolls over, in the case of cumulative preference shares). Interest payments on corporate debt must still be paid whether or not the company has made a profit.
2. Everything else being equal, because they face higher risk of non-payment of income and capital, investors should expect higher returns on preference shares than a corporate bond of the same capital.
3. Preference shareholders no not enjoy any charge over assets of the company, which usually benefits holder of debentures.
4. Even if the loan is unsecured, holders of corporate debt rank ahead of preference shareholders on repayment of capital in any liquidation event. As preference shareholders usually rank behind all creditors other than the ordinary shareholders, it’s very possible they’ll receive no repayment of capital.
5. The market price of preference shares tends to fluctuate far more than that of debentures.

Disadvantages of preference shares for the issuing company

Compared with ordinary shares:

1. If a second (or further) class of share is created to support preference shares, it adds extra complexity to managing the company’s share capital. Initially, the company’s articles of association are likely to require updating, and from that point on it’ll be necessary to study the respective rights of different share classes when there are profits to distribute or decisions to be made by shareholders. This complexity will be exacerbated if the preference shares have tailored rights.
2. There may be hostility from some existing ordinary shareholders, if the additional rights that apply to preference shares are seen as unfair. Particularly if some of those ordinary shareholders are also involved in management of the business, it has the potential to create tension and conflict.
3. A combination of these factors may also make shares in the company, whether preferred or ordinary, less attractive to those investors who want a clear view of their stake in the company and how their rights relate to those of other shareholders. This may make it tougher for the company to raise capital by issuing shares.

Compared with corporate bonds:

1. The cost for the company of raising capital via preference shares will generally be higher than issuing debt securities. That’s because investors expect a higher rate of dividend to compensate for the higher risk attached to shares compared with debt securities.
2. A preference share dividend is not a deductible expense for the company, unlike interest on a debenture or other corporate debt. Therefore, there is a tax disadvantage for the company.
3. Cumulative preference shares, unless they are redeemable, become a permanent burden for the company. In terms of dividends, their preferential rights can be restrictive where there is a particular desire to make a dividend distribution to the company’s ordinary shareholders.